Expected Value and Process
We always have to make decisions in life with imperfect information; we cannot predict the future with any great deal of accuracy. In hindsight, you may be able to say that investing in banks and gold miners was the optimal strategy, and everything else in the index was just weighing you down, or that US and international investments should have been a stronger weighting. But in advance, it is nearly impossible to make these kinds of calls correctly and consistently. So diversifying broadly helps protect us against surprises and bad guesses, and best work towards an acceptable expected value.
Similarly, some people will luck into mutual funds that earn more than their fee in returns and out-perform a passive indexing approach. Most, however, won't. So the best decision to make in advance is to avoid the mutual fund fees, control your costs and your complexity, and invest in index funds.
You cannot control outcomes, except to position yourself to make the best decisions you can with the information available at the time, to maximize your expected value and protect yourself from some of the most likely sources of failure. Processes are very important for long-term success. I have the following quotation from John Hempton enshrined on my desktop: “...I realized that the processes were as important as the outcome. Indeed they are more important.” [77]
A good process will help you best position yourself for the uncertain future, and adapt as outcomes change. Sometimes you will be wrong based on the outcome. For instance, if you split your investments half into bonds and half into stocks, and then see stocks crash. But based on what you knew at the time, that was a good choice to make, and you would make it again after the crash – so you rebalance, and buy more stock.
Trying to over-complicate, over-fit, over-optimize, or over-manage your investments is not a good approach to create a sustainable process. A common error is to have such a revulsion to paying tax that people jump into convoluted schemes and products that end up losing them money on the whole. For example, don't buy money-losing rental properties in order to get a tax deduction. Losing money is losing money, and hating tax so much that you'd rather lose $5 yourself to avoid having to give $1 of it to the government is irrational.
Accepting that information and estimates are imperfect and adapting as the situation changes is a key component of a good process. If you were driving along a road and saw a stop sign, you might estimate that you need 100 feet to stop smoothly. When you see that you're close to 100 feet away you would apply the brake and continue to watch and adjust – you would not just apply the initial estimate of pressure, close your eyes, and hope to wake up 10 seconds later behind the line rather than in the intersection.
So too with investing: if after ten years you see your savings rate is not keeping you on track to meet your long-term goals, you can adjust it. I have laid out some rules of thumb and information to help you create good investing processes to work towards your future dreams.
Your processes should be:
Footnotes:
77: John Hempton from the Bronte Capital blog, January 20, 2009:
http://brontecapital.blogspot.ca/2009/01/slogan-for-new-administration.html